Who to Blame When the Next Bubble Bursts

Any assessment of Alan Greenspan's long tenure at the Federal Reserve has to present the stock bubble as his biggest failure. If Greenspan had effectively and consistently warned investors of the irrationality of stock prices in the late 1990s, the bubble never would have reached such dangerous proportions. His "irrational exuberance" comment just wasn't enough.

The collapse of the bubble, which destroyed more than $8 trillion in paper wealth, was the immediate cause of the 2001 recession and the economy's subsequent period of weak growth and failure to create jobs. The collapse also left pension funds unbalanced and forced millions of workers to delay retirement. After his failure regarding the largest financial bubble in the history of the world, it looks like Greenspan is now actively promoting the world's second-biggest bubble: the housing market.

The basic story is simple: Over the last eight years housing prices have outpaced the overall rate of inflation by more than 35 percentage points. There is no precedent for this sort of rise in home prices. In the past, home prices largely kept even with the general rate of inflation.

The housing bulls have a number of explanations for this increase in home prices: a growing population, a limited supply of urban land, environmental restrictions on development. But these stories are no better than the "new economy" yarns of those who defended the stock market bubble. We have always had a growing population and limited supplies of urban land, and environmental restrictions predated the mid-1990s. These factors never led to elevated home prices in prior decades, which is why experts are warning about a housing bubble.

Fortunately, it is not necessary to get into these details to prove that there is a housing bubble. If underlying factors, rather than irrational exuberance, are the basis for the increase in home prices, then these factors should be having the same effect on rental prices. Studies have shown that, historically, rents and home prices have appreciated together. In other words, underlying factors will drive up home sale prices and rental prices by roughly the same amount. The rental markets tell a different story.

From 1998 to 2001, rental prices rose more rapidly than the overall rate of inflation, but not nearly as fast as home prices. If higher home prices are the result of a real shortage of housing, then rental prices should continue to rise to catch up with homes prices. That isn't happening. Rental prices are barely moving as record vacancy rates nationwide force landlords to hold the line on rents. In bubble areas, such as Seattle and San Francisco, rents are falling.

Where does Greenspan fit in?

He has promoted the housing bubble by reassuring people in public statements that there is no bubble. He also helped drive mortgage interest rates to 40-year lows earlier this year — allowing people to spend more money on houses, which adds to price inflation and to the bubble.

The health of the economy will be the key to George W. Bush's reelection. Over the last three years, the housing market has been the driving force in the economy. Greenspan appears determined to have it keep playing that role as long as possible. But the bubble will eventually burst, leading to another recession and destroying the main source of savings for tens of millions of families. Could a responsible public official possibly pursue such a policy?

When President Bush's first tax cut was being debated before Congress in January 2001, the public anxiously awaited Greenspan's views. He told Congress that the tax cuts were a good idea and that he was worried that without them the budget surpluses would be too large and that the government would pay off the national debt too quickly.

Three years later, we face huge budget deficits. There is no reason to ask whether Greenspan — who doesn't have to answer to anyone — would pursue a destructive economic policy for political reasons because he has already done so.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.